Inventory Management:

Getting Started

1. What is Inventory? 6. Inventory Valuation

2. What is "Inventory Management"? 7. Inventory Management System
3. Types of Inventory 8. Economic Order Quantity (EOQ)
4. Purpose of Holding Inventory 9. The ABCs of Inventory Classication
5. Inventory Costs 10. Inventory Performance Metrics

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What is Inventory?
Put simply, inventory is the
quantity of materials or stu
in storage. Within the context
of this ebook, it refers to all
forms of material intended for
sale kept by an organization.

inventory is a big part of a company's

assets, but it can also be a liability that
ties up an organizations working
capital. Having too little inventory can
be as costly as having too much.

The key to a successful business lies

in guring out the optimum way to
manage your supply chain.

ge
s to stora
tu goe
This s

1
 g t ra ck of
in
Keep n-hand
-o
stock

What is
Inventory Management?
The core concept behind inventory management is to ensure
you have the right amount of inventory, in the right place, at the
right time, at the right cost.

Keeping track of your stock-on-hand hand is just to carry an excessive

helps to optimize your inventory to
satisfy customer demand in the
market for products and services,
without exposing the company to
unnecessary costs and risks.
It seems that the simplest approach to
always have enough inventory on
amount of inventory.
Yet keeping excessive inventory on
hand for indenite sales will drain the
resources of a business especially
since inventory makes up the largest
percentage of costs for many retail
and wholesale businesses.

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Types of Inventory
Dierent classes of inventory need to be managed dierently to
match your business objectives. On a basic level, we have:

WORK IN PROGRESS (WIP) FINISHED GOODS

Items which are in the process of Items which are ready for purchase
conversion into the nished product. and consumption.

SUISSE
SUISSE
100g 100g
Gold Gold
999.9 999.9

MAINTENANCE, REPAIR & RAW MATERIALS

OPERATING ITEMS (MRO) Materials which can be converted into
Miscellaneous items which are not components or products, such as gold
directly part of the production chain, which is used for jewellery.
such as tools and oce supplies.

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 From a functional perspective, we have:

CURRENT-DEMAND STOCK TRANSIT INVENTORY

This is inventory for immediate use This is inventory en route from one
that is computed based on the place to another. Also known as
current expected demand. pipeline stock.

25F EB

ANTICIPATION STOCK SAFETY STOCK

Limited capacity to produce the Also called buer stock, this is the
inventory during peak seasons results in extra inventory thats carried to serve
the need to acquire inventory earlier in as a cushion for uncertainties in supply
anticipation of demand. and demand.

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Purpose Of Holding Inventory
Understanding the dierent reasons for holding inventory
helps you to manage your supply chain.

UNRELIABILITY OF SUPPLY
Holding inventory protects you from
unreliable suppliers, or when an item
is scarce and without the guarantee of
a steady supply of stock.

FLUCTUATION IN DEMAND
As demand levels are never an
absolute certainty, holding extra
inventory can enable organizations to
$
meet unexpected surges in demand.

QUANTITY DISCOUNTS
Many suppliers oer discounts based
A lot of on certain quantity breaks, because
coupons large orders tend to reduce total
book processing and shipping costs thanks
to economies of scale.

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Inventory Costs
Maintaining inventory is expensive, so factoring in inventory
costs will help in deciding the order quantity.

1 Includes all costs involved with placing an order

and procurement. It also includes associated
ORDERING
labor costs, for example: clerical and processing.
COSTS

2 The cost of storage for physical inventory.

$
This includes facilities, insurance, tax and
HOLDING
handling etc.
COSTS

3 Incurred when theres a stock shortage. This

reects the loss of sale and the corresponding loss
SHORTAGE in revenue/prot. Also includes the possibility of
COSTS
losing goodwill when customers leave because
they can't wait for the next batch of stock to arrive.
$
$

$
$
$

$
$
$

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 Inventory Valuation
Inventory valuation is to determine an organization's prot, and
an understanding of the nancial importance of inventory is key
to measuring its impact on cash ow.

Last-In, Specic Cost

First-Out (LIFO) Method
LIFO assumes that This method
the most recently requires tracking
First-In, Average Cost
purchased/acquired the actual cost of
First-Out (FIFO) Method
goods are the rst each individual unit
FIFO assumes that to be used or sold, This inventory of merchandise
the rst goods regardless of the valuation identies from beginning to
purchased are the actual timing of the value of the end -- best suited
rst to be used or their use or sale. inventory and cost for an environment
sold, regardless of of goods sold, by without much
the actual timing of This method best calculating an inventory to track.
their use or sale. matches current average unit cost
costs with current for all goods This complicated
This method is revenues. available for sale method usually
closely tied to the during a given requires the use of
actual physical ow period of time. a sophisticated
of goods in the tracking system.
inventory. This method treats
all inventory in the
same way, thereby
levelling out price
uctuations.

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The impact on bottom line and the taxes that an organization
must pay is closely tied to the inventory valuation method thats
used. This is best shown with the example below.

IT EM DAT E PUR CH ASED COST R E TA IL

Shirt 1 October $1 $5

2 October $2 $5

3 October $3 $5

First-In, First-Out (FIFO) LIFO Valuation

We assume that the rst item We assume that the last item
bought is also the rst item bought is also the rst item
thats sold. thats sold.

Revenue: $5 Revenue: $5
Cost of Goods Sold (COGS): $1 Cost of Goods Sold (COGS): $3
Gross Prot: $4 Gross Prot: $2

Based on the examples, we

Average Cost Valuation can safely conclude that:
To calculate the average cost. FIFO valuation: gives a high gross
$1 + $2 + $3 = $6 prot = higher taxation.
$6 / 3 = $2
LIFO valuation: gives a low gross
prot = reects a poor COGS.
Revenue: $5
Cost of Goods Sold (COGS): $2
Average Cost valuation: gives a
Gross Prot: $3 balanced evaluation.

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Setting up an
Inventory Management System
Inventory management is for more than just implementing a
process. It also allows you to set up a standard system through
which you can manage and streamline your inventory and
business eciency.

If inventory management is the

process of knowing what stock is on
hand, its important that we base our
purchasing on anticipated demands to
What item should be make better procurement decisions.
1
ordered?
So, how do we track and monitor all of
How much of each item
2 this information? The most important
should be ordered?
questions are as follows: (please refer
When should we order to the image on the left).
3
more of an item?
Given the complexity of this task, the
Which items are selling solution is surprisingly direct. By
4
well? Whats not doing well? leveraging an inventory system, all of
these questions can be answered
Are we holding too much
5 without much hassle.
stock?

What is the Return on The minimum requirement for a

6 system is that it helps you keep track
Investment on my stock?
of when and how much to order.

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 FIXED-TIME PERIOD A DV A N TA GE S
SYSTEM (PERIODIC)
Because orders are made in bulk,
organizations can take advantage
The inventory levels are checked of quantity discounts

periodically, and the quantity of Less administrative process since

stock ordered can vary. orders are made in one sweep

A target inventory level is

maintained in the system and
inventory is checked in intervals
(for instance every week or every
two weeks). Orders are then placed
to restore inventory levels to the
target quantity set.
DIS A DV A N TA GE S
Since inventory level is not checked
on a regular basis, a sudden surge of
demand can lead to a stock out
Gaps in stock movement leads to
lesser visibility and accuracy

ADVANTAGES FIXED-ORDER QUANTITY

SYSTEM (PERPETUAL)
Provides real time view of
inventory level
The quantity of stock ordered with
Provides greater system
responsiveness this system is constant or xed.

An order is placed when the

DISADVANTAGES
It requires plenty of administrative
processes when orders need to be
made and received
Diculty in obtaining quantity
discounts that leads to high ordering
costs due to the random nature of
reordering
inventory level drops to a level
that marks the reorder point. With
this system, the inventory is
checked on a continual basis and
the current level of inventory is
assumed to be known.

The dierence between these two systems lies in the timing and quantity of
orders placed. Under the perpetual system, inventory levels are checked
continually and orders may be sporadic. Under the periodic system, inventory
levels are checked and orders are made based on the specied time interval.
Ultimately, your choice will depend on the overall objectives of your business.

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An Introduction to Economic Order
Quantity (EOQ)
The economic order quantity equation helps to decide the best
order quantity that minimizes total inventory holding costs and
ordering costs.

Q* = 2 D K
D = F I X E D C OST PE R
YE A R

K = DE MA ND IN
UN I T S P E R Y E AR

H = C ARRY I NG C OST
h
P E R UNI T PE R Y E AR

Alternatively, you can use a free online calculator to help with EOQ calculations
http://www.ultimatecalculators.com/economic_order_quantity_calculator.html

Reorder Point (ROP) Safety Stock (SS)

While EOQs help you decide what to
order, ROP answers the question of
when to order. To do so requires the
knowledge of lead time the interval
of how long it takes for the supplier to
restock the inventory.
This would ensure that there is
enough stock to cater to demand
during this period.
In a perfect world, we can assume that
demand and lead times are always
constant. In reality however, these
variables can uctuate quite
dramatically. The purpose of safety
stock is to lessen the risk of these
uncertainties.
This is done by ordering buer stock
on top of the value dened in the ROP.

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Based on Paretos 80/20 law, a small percentage of items in the
inventory can account for a large percentage of value.
The value of an item is decided
through sales and prots. ABC
classication can be assessed by:
Annual sales
Percentage of sales for each item
Ranking and classication from
highest to lowest
The ABCs of
Inventory
Classication
Identifying your bestsellers
and prioritizing importance
based on high impact and
value will help prevent the
waste of precious resources
(especially time).
We can use the ABC classication in
order of priority items in group A are
the top-sellers you want to keep the
closest eye on, group Bs items are of
relative importance, and group C is of
the least importance.
After setting up these classications,
we can assign dierent management
strategies for each tier to match their
importance.
Get more bang for your buck when
you focus more on the fast-moving
items that have a greater impact on
the business.
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Inventory Performance Metrics
Given the importance of inventory management on the nancial
and operational value in any organization, its important to
regularly measure and evaluate processes.

These can range from accuracy of records, eciency of storage methods, units
available, and dollar value tied to inventory. There are, however, two standard
metrics to measure the eciency of your inventory management and the
nancial health of your organization.

Inventory to Sales Ratio

This measures the inventory quantity
relative to the number of fullled sales
orders. The aim is to keep the
inventory to sales ratio low, which
indicates productive use and
minimized cost of carry.

Inventory Turnover
This measures how quickly the
inventory is cycling through your
business. A higher turnover value is a
general indicator of success, but be
careful if its too high. An extremely
high turnover could also be an
indicator of pricing thats too low, or
inecient inventory forecasting.

Thank you for reading!

Understanding the fundamentals of proper inventory
management is the rst step to sales success.

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